By Richard V. Hrvatin, Dr. Stefan Bund, John Schiavetta, and Kenneth Gill of Fitch Ratings

Fitch Ratings will launch its global CDO criteria this week with a series of conferences held in major European cities. The new criteria apply to all CDO types with the exception of market value CDOs, trust preferred CDOs and private equity and hedge fund CFOs.

The below excerpt - provided exclusively to Asset Securitization Report - focuses on Fitch's new Default VECTOR model. However, the new CDO rating criteria include many new enhancements, such as:

* Multi-step Monte Carlo simulation;

* Incorporation of asset specific correlation assumptions;

* Recovery assumptions tiered by rating stress;

* Empirically based Fitch CDO Default Matrix;

* Adjusted rating factors;

* Revised interest rate stresses;

* Explicit reinvestment assumptions; and

* Adjustment for asset manager ratings.

For a detailed discussion of all the analytical enhancements, the complete CDO criteria can be found on Fitch's Web site at

CDO performance is directly linked to three pillars: the behavior of the underlying assets, the CDO's structural features and the CDO's asset manager performance. All of these variables are addressed in the new criteria through the Default VECTOR model, policies regarding structural features, and adjustments based on Fitch's CDO asset manager ratings.


VECTOR is Fitch's main quantitative tool to evaluate the default risk of credit portfolios in CDO transactions. VECTOR, developed jointly with Gifford Fong Associates from Lafayette, California, allows greater precision and granularity in portfolio risk modeling when evaluating and rating a CDO.

VECTOR is a multi- period Monte Carlo Simulation model, which simulates the default behavior of individual assets for each year of the transaction. Monte Carlo Simulation is widely used in finance and allows modeling the distribution of portfolio defaults and losses, taking into account the default probability and recovery rate as well as the correlation between assets in a portfolio.

VECTOR is based on a structural form methodology, which holds that a firm defaults when the value of its assets falls below the value of its liabilities. The model simulates correlated asset values for each obligor and each period, which is compared to the default threshold derived from the rating and its corresponding default probability in the Default Matrix.

VECTOR applies an annual multi-step process. At every annual step the asset portfolio is updated, whereby defaulted assets are removed, and default amounts and recoveries upon default are recorded. VECTOR simulates the asset values for each year of the transaction, which allows one to model time varying inputs such as correlation and default rates, and the ability to incorporate amortization characteristics of every individual portfolio.

Correlation between Assets

One of the key components of VECTOR is the explicit incorporation of correlation between individual assets in a CDO. As mentioned above, the structural form methodology applied in VECTOR models the asset value of individual obligors. Therefore, the model requires asset correlation as input, which measures the degree by which the asset values between two obligors move together across time. Asset correlation is different from default correlation, which measure the relationship between the events of default of two assets.

Correlation between Corporates

Measuring the asset correlation between corporates directly was not possible, since historical time series of asset values are generally not readily available. Therefore, Fitch used equity return correlation as a proxy for asset correlation. In order to do so, a factor analysis was applied. Fitch, together with Gifford Fong Associates, analysed a global data set of 989 and 1584 publicly listed companies in Europe and the U.S., respectively.

Correlation between Structured Finance Products

Due to the lack of data, correlation assumptions between structured finance products were established using expert knowledge. Structured finance securities are typically built on diverse asset portfolios, which are much less exposed to idiosyncratic or event risk. Portfolio theory shows that the lower the idiosyncratic risk inherent in assets, the higher the correlation between such assets. The level of diversity between structured finance products depends on the number of assets in the portfolio, their regional and industry distribution and their level of cross holdings.

VECTOR Outputs

VECTOR is not a cash-flow model and does not take into account the structural features such as waterfalls or excess spread. The VECTOR outputs reflect the credit quality of the portfolio underlying each individual CDO.

The primary outputs of the VECTOR model are:

* Portfolio Correlation Level

* Rating Default Rate

* Rating Loss Rate

* Rating Recovery Rate

* Default Distribution over Term

Portfolio Correlation Level (PCL) - The PCL is an average correlation statistic for the given portfolio in VECTOR, based on Fitch's correlation assumptions. Each industry has a unique correlation profile with respect to every other industry, and every portfolio will produce its unique PCL. PCL enables the user to view the impact of portfolio changes on the portfolio's correlation level. Since correlation has a direct impact on the scenario default rates of the portfolio, the purpose of the PCL is to give users an indication of the level of correlation in a portfolio. Changing the correlation and hence the PCL will change the default level. The PCL is a pre-simulation statistic.

Rating Default Rate (RDR) - The RDR shows the percentage of the initial portfolio that is assumed to default in the respective rating scenario. It is derived from the portfolio default distribution, applying the percentile corresponding to the rating scenario and term. The percentile applied for a particular target rating incorporates the fact that the values in the Default Matrix are supposed to be average default probabilities. If there is no value that directly matches a given percentile, then the value that is equal to or greater than corresponding percentile is taken. In the chart below the closest percentile is 96.3, which corresponds to a default rate of 32.2%. The RDR is a direct input into the cash-flow model (discussed below).

Rating Loss Rate (RLR) - This number shows the expected portfolio loss for the particular credit portfolio in the respective rating scenario. The portfolio loss is calculated using Fitch's recovery rate assumptions for each asset, taking into account the asset's jurisdiction, its ranking in the capital structure of the issuer and the rating stress level. The RLR is gross of any structural mitigates as e.g. excess spread. It is derived from the portfolio loss distribution in the same way as the RDR. In the absence of structural support, static credit enhancement has to cover the RLR for the respective rating.

Rating Recovery Rate (RRR) - The RRR shows the expected weighted average recovery rate of the particular credit portfolio in the respective rating scenario. In the past, this number was calculated on pre-simulation basis over all assets in the portfolio, ignoring whether an asset is likely to default or not.

This simplistic analysis fails to capture two important risk factors. The first is that recovery rates are scenario-sensitive. The second is that of barbelling of recovery rates and ratings. If assets in the pool are not homogenous, the differing default rates among the assets could produce different actual recovery rates on a portfolio basis. The extent of the difference depends on the relative difference in default rates.

The VECTOR model captures this difference in the RRR.

Default Distribution over Term (DDT) - The DDT shows the expected allocation of portfolio defaults over the term of the simulation. The DDT will be used as a default timing scenario in the cash- flow model.

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